Wescott’s 2014 Global Asset Allocation Perspective

February 14, 2014

Our first report was published in 2005 and updated in 2006; the initial reports discussed our decision to increase our allocation to non-U.S. equities and the phased-in implementation. Since early 2007, 40% of our allocation to equities has been allocated to non- U.S. equities (for a 60% equity portfolio, 12% of the total portfolio is allocated to non-U.S. companies). Our 2011 updated report discussed the changes made in early 2012 to include several global equity strategies to position portfolios for the rapidly changing global demographics. At that time, we added exposure to energy, global real estate and global natural resources.

We are now five years beyond the credit crisis that shook the developed world and dampened the appetite of many investors for non-U.S. equities. We have not changed our allocation because we believe the reasons are even more compelling today than they were pre-crisis. In this edition, we want to share our view of this rapidly changing world, and those areas that we have identified as the true “game changers” for the decades ahead. This paper synthesizes research and data that have not been making the head- lines. The media focuses on short sound bites like “China is slowing” or “IMF has lowered forecasts for global growth” – investors need to be better informed to benefit from what lies ahead.

Through 2013, the U.S. market outperformed the MSCI All Country World ex US (MSCI ACWI ex -US) in only four of the 11 years since 2003 (2008, 2010, 2011 and 2013). The past several years have seen non-U.S. markets out of favor, much as they were in the late 1990s. The global market declines of early 2000-2002 and the 2008 financial crisis did not leave these markets unscathed. However, it is during out of favor times that our managers have more opportunities to buy great companies at cheap prices. We believe that a globally diversified portfolio gives you the probability of having something undervalued at all times. Our investments in non-U.S. companies allow us to participate in the dynamic changes taking place. Since inception, our allocation to non-U.S. equities has been an overall contributor to our results.

During 2013, the U.S. equity market rebounded to represent 49% of the World’s Market Capitalization in the MSCI All Country World Index (ACWI), after dropping to a low of 42% in 2009. However, based on purchasing power parity, the U.S. provided only 19% of global GDP in 2013, whereas the emerging markets provided 51% of global GDP. The world’s population has grown to 7 billion, up from 3.6 billion in 1970. During 2013, the U.S. represented only 4.46% of the 51% global population, versus 36% for China and India combined.

The report, The Rise of the South: Human Progress in a Diverse World, Human Development Report 2013, published by the United Nations Development Programme (UNDP) offers a wealth of information about the emergence of developing countries and the shifting relationship between developed and developing countries. The developed world is considered “The North”, and the developing world is “The South”.

This is not a discussion about a war between the states; it is a window into the future. While the countries in the North had a 2008 financial crisis and austerity programs to implement, countries in the developing South were building up foreign exchange reserves. By the third quarter of 2011, global foreign reserves had increased to $10.1 trillion, up from $1.9 trillion in 2000. The developing world had accumulated 67% of these reserves, or $6.8 trillion, which they were able to use to steady and grow their economies during the global financial crisis.

Highlights of the Human Development 2013 Report are:

1. For the first time in 150 years, the combined output of the developing world’s three leading economies— Brazil, China and India—is about equal to the combined GDP of the long-standing industrial powers of the North—Canada, France, Germany, Italy, the United Kingdom and the United States.

2. By 2025, annual consumption in the emerging market economies is projected to rise to $30 trillion, from $12 trillion in 2010, with the South home to three-fifths of the 1 billion households earning more than $20,000 a year.

3. In 2013, the South is producing about half of world economic output, up from about a third in 1990. The combined GDP of eight major developing countries alone – Argentina, Brazil, China, India, Indonesia, Mexico, South Africa and Turkey – now equals the GDP of the United States, still the world’s biggest national economy. However, as recently as 2005, the combined economic weight of those eight countries was barely half that of the United States.

4. Between 1990 and 2010, the South’s share of the global middle class population expanded from 26% to 58%. By 2030, more than 80% of the world’s middle class is projected to be living in the South and will account for 70% of total consumption expenditures. The Asia-Pacific region will host about two-thirds of the world’s middle class by 2030, Central and South America about 10% and Sub-Saharan Africa 2%. Within Asia, China and India will account for more than 75% of the middle class as well as its share of total consumption.

5. In North-South trade, the emerging markets became a manufacturing source for complex products intended for consumers in the developed countries. However, in South to South interactions, companies have adapted and innovated with new business models geared to making products in quantities for large numbers of low- income customers, often with low margins.

6. Four of the five countries with the greatest number of Facebook users are in the South: Brazil, India, Indonesia and Mexico.

On October 15, 2013, there were two different articles in The Wall Street Journal about companies looking for a broader global reach for emerging middle class consumers by making products more affordable.

One article featured the Swedish company IKEA, which ships about one mil- lion kitchens a year, costing as little as $3,000. Their design goal is “democratic design” that can work in Beijing, China or Topeka, Kansas. The second article discussed how Tata Motors is retooling the Nano after learning that Indian consumers don’t want cheap cars that lack conveniences for $2,000 and are willing to pay more for air conditioning, a four-speaker sound system and a nicer interior. Their top-end Nano LX will sell for $3,578; the company also owns Jaguar and Land Rover.

The Two Near-Term Game Changers: China and Africa
In its 2013 report, the Population Reference Bureau projects population changes from 2013 to 2050. The countries with the largest projected populations offer a glimpse of how the global economy must adapt.

Africa is projected to have the largest population growth of 1.3 billion, bringing the continent’s population to 2.4 billion, with most of the growth in the countries of sub-Saharan Africa. These projections assume that birth rates will decline due to more family planning; if birth rates continue at current rates, the population in Africa could be much larger. Growth in the middle class has been strongest in China and Africa, making them the focus for our global outlook.

How China Is Changing The Global Economy
China has made incredible progress in lifting its people out of poverty: 510 million in the period from 1990 to 2008, and urbanization projects continue. Over the next 12 years, the government’s goal is to move another 250 million people from rural areas to cities and towns yet to be built.

The McKinsey Quarterly 2013 Number 3, China’s Next Chapter (www.mckinsey.com/quarterly), provides statistics of great interest to consumer-related companies.

1. The rapidly growing middle class (making between $9,000 to $34,000 a year in 2010 dollars) has climbed from 4% of urban Chinese households in 2000, to 68% in 2012, and is projected to be more than 75% of urban consumers by 2022. McKinsey estimates that by 2022 (only eight years away), the upper middle class (earning from $15,750 to $34,000 a year) will account for 54% of urban households and 56% of urban private consumption.

2. Chinese consumers will be the source of demand for “more than one-third of the money spent around the world on high-end bags, shoes, watches, jewelry and ready-to-wear clothing” by 2015; this will come from China’s domestic market and beyond.

3. The new middle class in China includes Generation 2 consumers (the most Westernized to date) that will be almost three times as large as the baby-boomer population that has driven U.S. consumption. Retailing is undergoing a “leapfrog effect” in China; this is also common to other developing countries.

4. With a country the size of China, it is difficult for traditional retailing to make its way to the many smaller cities. China has become the world’s second largest “e-tail market”, which McKinsey estimates generated revenues of up to $210 billion in 2012. Companies that are most dominant include PaiPai, Taobao (owned by Alibaba) and TMall. Online shopping is showing some interesting trends—buying is higher in the country’s less developed and smaller cities, giving the Chinese better access to products and at cheaper prices.

5. McKinsey is projecting that by 2020, China’s e-tailing market will be equal to the aggregate current market of the United States, the United Kingdom, France, Japan and Germany.

Examples of Innovation in China:
In 2005, Lenovo bought IBM’s personal computer business. In 2013, the company launched its Horizon table PC that can be used for gaming or group projects. In a conversation with McKinsey, Chairman and CEO Yang Yuanqing said, “We don’t think there’s a post-PC era – we see a PC-plus era. We know that the PC is no longer the only Internet-access device, but it’s still critical”. After establishing a strong foundation in China, the U.S., Japan and Germany, the company is moving into Brazil, India and Russia.

Huawei attracted attention at the 2013 Consumer Electronics Show in Las Vegas with an innovative new smartphone platform built on chips and soft- ware designed in-house. Xiaomi is another smartphone maker; the company started in 2010 and is compared favorably to Apple, Inc. McKinsey’s report also highlights YY.com, a voice-based communications and gaming service with mass online karaoke.

For several years, we have tracked the world’s largest shopping malls as an indicator of trends in retailing and consumption. As you can see in the following table, none of the top 10 by size are in the United States, with Asia now playing a dominant role.

Developments in Africa: People, Trade and Technology
One of the greatest challenges that Africa faces is that half of its population is under 20 years old; this is also one of its greatest advantages in that this group is incredibly adaptive, particularly as it concerns technology. The McKinsey report discusses the way that Africa has used mobile phones to “leapfrog” without the need for expensive land lines. In early 2011, the Chinese company, Huawei, launched an affordable $80 smartphone through Kenya’s telecom company, Safari. com, and sold 350,000 in less than six months—in a country where 60% live on less than $2 a day. The book Abundance, The Future is Brighter Than You Think includes a comparison of 2011, when there were 500 million mobile phones in Africa (only 15 million of which were smartphones) to projections for 2015 of 850 million mobile phones, including 127.5 million smartphones.

The Human Development Report 2013 cites the impact of technology and cell phone adoption on everyday life in Africa. “Take the uses to which Africans are putting affordable Asian-built mobile phones: cellular banking is cheaper and easier than opening a traditional bank account, farmers can obtain weather reports and check grain prices and entrepreneurs can provide business services through mobile phone kiosks. The use of mobile phones in Niger has improved the performance of the grain market; and Ugandan farmers are using mobile phones to obtain higher prices for their bananas”.

McKinsey’s October 2012 report, “The rise of the African consumer,” also provides insight about the changing dynamics in Africa, which has more than 50 countries. The growth area in Africa is concentrated primarily in 10 countries. Consumption trends in Africa are even stronger than Russia or India. While African consumers are “highly value-conscious,” they also “demand quality products and are brand conscious”. A common thread to the emerging middle class in all rapidly developing countries is that spending is becoming aspirational. The latest fashion and technology are prized. Internet penetration is high and escalating due to smart phones. In Africa, brand loyalty is very high, giving an edge to companies that tailor its products and partner to improve communities.

Companies in the developed world have a lot to gain from the developing world’s progress. Coca-Cola has been selling its products in Africa since 1929, and has a presence in every one of its countries; it is Africa’s largest employer. Recently, Coca-Cola partnered with the ColaLife foundation to use soda bottle crates to deliver anti-diarrhea medicine (which is in short supply in African pharmacies) in special kits. The AidPod received top honors in DuPont’s 2013 global packaging awards.

The EKOCENTER
Africa has 40% of its population living in urban areas where consumption is at double the rate in rural areas. Cities in Africa will be larger than in India and North America. McKinsey projects that 500 million Africans will be living in urban areas by 2016, with 65 cities housing more than a mil- lion people each, up from 52 cities of that size in 2011.
In the References section of Abundance, The Future is Brighter Than You Think, we found another way to look at Africa, and its massive potential.

The last decade was very productive in terms of technology and innovation. Products that are changing our lives are increasingly more complex, yet are designed to be easier to use, and are more accessible. We remain largely unaware of all the progress that has been achieved to solve some of the world’s thorniest problems, in large part because these developments don’t make the “news”. In their book, Abundance, The Future is Better Than You Think, authors Peter Diamandis and Steven Kotler give specific examples of already developed life-changing technologies and products that will have far-reaching implications. We highly recommend the book for its content and inspiration about what is already possible, and its discussion of the many people who are involved to create solutions that are within our reach.

References and Suggested Reading:

The World Is Flat, a Brief History Of The Twenty-First Century, by Thomas L. Friedman

The Age of the Unthinkable: Why the New World Disorder Constantly Surprises Us and What We Can Do About It, by Joshua Cooper Ramo

Abundance, The Future Is Better Than You Think, by Peter H. Diamandis and Steven Kotler

Breakout Nations, In Pursuit of the Next Economic Miracles, by Ruchir Sharma, portfolio manager, Morgan

Stanley Institutional Emerging Markets

Population Reference Bureau 2013 World Population Data Sheet www.prd.org

Human Development Report 2013, The Rise of the South: Human Progress in a Diverse World, published for the United Nations Development Programme http://hdr.undp.org

McKinsey October 2012, The rise of the African consumer, by McKinsey & Company www.mckinsey.com/ quarterly (free registration required to access the report)

McKinsey Quarterly 2013 Number 3, China’s next chapter, by McKinsey & Company www.mckinsey.com/quarterly (free registration required to access the report)

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